Chapter 3: Scarcity & Choice
Scarcity, Choice, Opportunity Cost
Resources are always limited = scarcity
Opportunity cost: value of the next best alternative forgone
When market functions well:
o Goods w/ high opportunity costs have high money costs
o Goods w/ low opportunity costs have low money costs
Scarcity & Choice: a Single Firm
One business firm: fixed supply of inputs, given technology
o Produce two outputs: more of one = less of other
Production possibilities frontier: different combinations of
various goods
o Slopes downward to right
o Bowed outward
o Slope = Opportunity cost
Principle of Increasing Costs: as production of a good expands,
opportunity cost of producing another unit generally increases
Scarcity & Choice: Entire Society
Economy is constrained by resources & technology
Production possibilities frontier: position & shape are determined by economy
The Concept of Efficiency
Efficiently produced output (with given technology), cannot increase output production w/out
increasing inputs or giving up other output
Three Coordination Tasks
1. How to utilize resources efficiently
a. Division of labor
b. Law of Comparative Advantage
One country, even if it’s worse than another country in production of every good, has a
comparative advantage in making the good at which it’s least inefficient compared to the other
country. The two countries can gain by trading.
2. Which of the possible combinations of goods to produce
a. Market mechanism: comparative advantage, trade goods for other goods, determine how
much to produce
3. How much of total output to distribute to each person
a. Market system
Chapter 4: Supply & Demand
The Invisible Hand
Adam Smith – father of modern economic analysis
o By pursuing their own self-interests, people in a market system are “led by an
invisible hand” to promote the well-being of the community
Demand & Quantity Demanded
Quantity demanded: number of units of a good that consumers are willing and can
afford to buy over a specified period of time
o Price dependent w/ all other things being equal
o Demand Schedule: shows how quantity demanded changes
o With all other determinants constant
As price rises, quantity demanded falls
As price falls, quantity demanded rises
o Demand Curve: graph of demand schedule
Change in price = movement along demand curve
Change in other determinants = shifts demand curve
o Consumers buy more = demand curve shifts right/outward
o Consumers buy less = demand curve shifts left/inward
Demand increases (outward shift of demand curve) as:
o Consumer income increases
o Population increases
o Consumer preferences are in favor
Price & availability of related goods
o Price of substitutes increase = demand increases (outward/right shift)
o Price of complements increase = demand decreases (inward/left shift)
Supply & Quantity Supplied
Quantity supplied: number of units that sellers want to sell over a specified period of time
o With all other determinants constant
As price rises, quantity supplied rises
As price falls, quantity supplied falls
o Supply schedule: shows how quantity supplied changes
o Supply curve: graph of supply schedule
Change in price = movement along supply curve
Change in other determinants = shifts supply curve
o Size of industry increases = supply increases = outward shift of supply curve
o Technological progress = reduces costs = supply increases = outward shift
o Price of inputs increase = supply decrease = inward shift
o Prices of related outputs/complements in production = increase price of one increases demand
for the other
Supply & Demand Equilibrium
Supply-Demand diagram: graphs the supply & demand curves
o Determines equilibrium price & quantity
Shortage: excess quantity demanded over quantity supplied
o Buyers cannot purchase quantities they desire at current
price
Surplus: excess quantity supplied over quantity demanded
o Sellers cannot sell the quantities they desire at current price
Equilibrium: no inherent forces that produce change
o Equilibrium changes: outside events
Law of Supply & Demand
o In a free market, the forces of supply & demand push the price
toward equilibrium level (quantity supplied = quantity
demanded)
o May be disobeyed
Long-term shortages, surpluses, prices fail to move toward equilibrium
Effects of Demand Shifts
Demand curve – shift outward/right
o w/ no change in supply curve, equilibrium price rises,
equilibrium quantity rises
Demand curve – shift inward/left
o w/ no change in supply curve, equilibrium price falls,
equilibrium quantity falls
Effects of Supply Shifts
Supply curve – shift outward/right
o w/ no change in demand curve, equilibrium price falls,
equilibrium quantity rises
Supply curve – shift inward/left
o w/ no change in demand curve, equilibrium price rises,
equilibrium quantity falls
Who really pays that tax?
New tax on product imposed on the seller
o Firms – decrease supply, pay part of tax
o Consumers – pay part of tax
o Equilibrium price increases by less than amount of tax
Price Ceilings
Maximum that the price charged for a commodity cannot legally
exceed; keeps price below free-market level
Consequences: persistent shortage develops, illegal market to
supply the commodity
Price Floors
Minimum below which the price charged for a commodity is not permitted to fall; keeps price above
free-market level
Symptoms: surplus (not enough buyers), disposal of goods, disguised discounts
Chapter 6: Demand & Elasticity
Elasticity
Measure of responsiveness
Price Elasticity of Demand: ratio of percentage change in quantity demanded to percentage change in
price; responsiveness of quantity demanded to price changes
Demand – elastic
o Elasticity > 1
o 10% rise in price = >10% drop in quantity demanded
o Relatively flat demand curve
Demand – inelastic
o Elasticity < 1
o 10% rise in price = <10% drop in quantity demanded
o Relatively steep demand curve
Price Elasticity of Demand = (QD/P)(Pavg/Qavg) Elasticity = 1
o QD = change in quantity demanded
o P = change in price
o Pavg = average price
o Qavg = average quantity
o If >1, price is elastic (decrease price)
o If <1, price is inelastic (increase price)
Total Revenue & Total Expenditure
Total Revenue = P x Q = Total Expenditure
o A point on a demand curve, area of rectangle under the point
Effects of Price Decrease
o Total revenue decreases because price decreases
o Total revenue increases because quantity increases
Effects of Price Increase
o Demand is elastic = total revenue will decrease
o Demand is unit elastic = total revenue will not change
o Demand is inelastic = total revenue will increase
What Determines Demand Elasticity?
Nature of the good
o Necessities = inelastic
o Luxuries – elastic
Availability of close substitutes
o Close substitutes: demand is more elastic
o No close substitutes: demand is inelastic
o Narrowly defined: more elastic
Share of consumer’s budget
o Small = inelastic; large = elastic
Passage of time
o Short run = inelastic; long run = elastic
Elasticity as a General Concept
Income elasticity of demand: ratio of percentage change in quantity demanded to percentage change
in income
Price elasticity of supply: ratio of percentage change in quantity supplied to percentage change in price
Cross elasticity of demand for X to a change in the price of Y: Ratio of percentage change in quantity
demanded of C to percentage change in price of Y
o Positive = substitutes
Substitutes: increase in quantity consumed of one decreases quantity demanded of
other
o Negative = complements
Complements: increase in quantity consumed of one increases quantity demanded of
other
Time Period of Demand Curve
Demand curve describes a set of hypothetical quantity responses to a set of potential prices, but the
firm can actually charge only one of these prices
All points on demand curve refer to alternative possibilities for the same time period (the period for
which the decision is to be made)
Chapter 7: Production, Inputs, & Costs: Building Blocks for Supply Analysis
Short-Run vs. Long-Run Costs
Short run: some of the firm’s cost commitments will not have ended
Long run: period of time long enough for all of the firm’s current commitments to come to an end
Fixed cost: cost of an input whose quantity does not rise when output increases
o Does not change when the output changes
Variable cost: varies with output
One Variable Input
Total physical product (TPP): total output from a given quantity of input
o TPP curve: how much output can be produced with different
quantities of one variable resource
Average physical product (APP): output per unit of input
o APP = TPP / X
Marginal physical product (MPP): increase in total output from a one-unit
increase in input quantity
o MPP curve: reports rate at which TPP changes; equals slope of
TPP curve
o Increasing marginal returns = MPP increasing, TPP
increases at an increasing rate
o Diminishing marginal returns = MPP decreases, MPP is
positive, TPP increases at a decreasing rate
o Negative marginal returns = MPP is negative, TPP
decreases
o “Law” of Diminishing Marginal Returns
An increase in the amount of any one input
ultimately leads to lower marginal returns to the
expanding input
Marginal revenue product (MRP): additional revenue that the producer earns from increased sales
when it uses an additional unit of input
o MRP = MPP x Price (P) of output
o Maximize Profits
Profit = Total Revenue (TR) – Total Cost (TC)
MRP > P of input = use more input
MRP < P of input = use less input
MRP = P of input = optimal quantity of input
Multiple Input Decisions
I don’t think this is covered on exam, Chapter 7 slides 16-18
Cost & its Dependence on Output
Total Cost (TC): cost of fixed inputs, variable inputs, opportunity costs
Average Cost (AC): total cost divided by quantity produced (TC / X = AC)
Marginal Cost (MC): increase in total cost form production of one additional
unit of output
Total Variable Cost (TVC): cost of variable inputs
o TVC curve rises steady w/ output
Average Variable Cost (AVC): total variable cost /
quantity produced
o AVC curve is U-shaped
Marginal Variable Cost (MVC): increase in TVC from one additional unit of output
o MVC curve is U-Shaped
Total Fixed Cost (TFC): doesn’t vary with output
o TFC curve is straight horizontal line
Average Fixed Cost (AFC): total fixed cost / quantity
produced
o AFC curve decreases w/ output
Marginal fixed costs (MFC): always zero
Total Cost: TC = TFC + TVC
Average Cost: AC = AFC + AVC
o AC curve is U-shaped
Downward-sloping segment = increasing MPP, spread fixed
costs
Upward-sloping segment = rise in administrative costs
Marginal Cost: MC = MFC + MVC = 0 + MVC = MVC
Average (& marginal & total) Cost Curve depends on firm’s planning horizon
Long run average (& total) cost curve is different than short run
o In the long run input quantities become variable
Economies of Scale
Increasing returns to scale if, when all input quantities are increased by X percent, the quantity of
output rises by more than X percent
o Long run AC curves decline as output
expands
Constant returns to scale if, when all input
quantities increase by X%, total cost increases
by X% and quantity of output rises by X%
o AC remains constant (horizontal AC
curve)
Decreasing returns to scale if, when all input
quantities increase by X%, total cost increases by X% and quantity of output rises by less than X%
o Rising AC curve
Returns to a single input: how much does output expand if a firm increases the quantity of just one
input
Returns to scale: how much does output expand if all inputs are increased simultaneously by the same
percentage
Chapter 8: Output, Price, and Profit: Importance of Marginal Analysis
Price & Quantity: One Decision
Optimal decision: best amount possible decisions
Firm – select price: quantity up to consumers
Firm – select quantity: price determined by market
Firm’s demand curve: each point is a price quantity pair
Total Profit
Firm’s objective is to maximize profit
Total profit = net earnings
o Total Revenue – Total Cost (including opportunity cost for economic profit)
Economic Profit
If > 0, firm’s decisions are optimal
If = 0, satisfactory decisions
If < 0, not optimal (at least one alternative price-output combination
that is more profitable)
Economic Profit = Accounting Profit – Opportunity Cost
Total Revenue (TR): total amount of
money receives from purchasers of
products (TR = P x Q)
Average Revenue (AR): total revenue
divided by quantity
o AR = TR / Q = (P x Q)/Q = P
Marginal Revenue (MR): addition to
total revenue from addition of one unit
to total output
o MR1 = TR1 – TR0
o MR = slope of TR curve
Total Cost (TC) curve: increases w/
output
Average Cost (AC) curve: U-shaped
Marginal Cost (MC) curve: u-shaped
Maximize Total Profit
o TR – TC
o Graphically, vertical distance between TR curve & TC curve
Marginal Analysis
Marginal Profit: addition to total profit from one more unit of output, slope of total profit curve
Optimal level of output
o If marginal profit > 0: increase output
o If marginal profit < 0: decrease output
o If marginal profit = 0: optimal output
Maximize Profit: Marginal profit = 0
Marginal Revenue (MR): slope of TR curve
Marginal Cost (MC): slope of TC curve
Maximize Profit: output quantity: MR = MC, price on the
demand curve
